Thursday, September 03, 2009

The real reason why health care costs keep going up.

The main factor is that the long-term income elasticity of the demand for health care is 1.6 -- for every 1 percent increase in a family's income, the family wants to increase its expenditures on health care by 1.6 percent. This is not a new trend... [ht: Arnold Kling]

What he's saying is that health care is a "superior good". This is a good that people want to spend a larger percentage of their income on, as their income rises.

The logic works like this: The value provided by most consumer expenditures is subject to diminishing returns -- additional amounts spent produce less and less "reward", value to the consumer.

For instance, the first car you buy may be vital to your earning an income if you need it for work, so you will pay good money for a good-and-reliable one. Your family's second car is a convenience, so you'd pay less for it. The third car is just so the teenagers won't drive one of the two good ones -- you get 'em a clunker ... there isn't going to be any fifth car on your bill, if the kids all want their own they can get jobs and buy them themselves.

(Or: The first calories you consume are essential to keep you alive. But those last calories you just consumed only put you that much closer to diabetes, heart attack and not being able to lift yourself out of your chair -- they had negative value and you'd have done better without them.)

A superior good is one that produces closer to constant rather than diminishing returns -- so as expenditures on "diminishing return goods" produce less benefit for you, you shift your additional expenditures to the superior good.

Spending that extends your life in good health always produces a valuable benefit for you, so you shift steadily more of your income to it as you finally buy all the cars you can drive, flat-screen TVs you can watch, and food you can choke down.

It follows that since consumers' incomes generally rise with overall economic growth as the years pass, total spending on health care rises faster than income -- because that's what people want.

Professor Mankiw has expanded on this and quoted detailed analysis concluding:

...based on the quantitative analysis of our model, the optimal health share of spending seems likely to exceed 30 percent by the middle of the century.

This is not just in the US, it is universal in all developed economies.

As noted here before, the average rate of "excessive growth" in health care costs (the amount by which they grow faster than GDP) since 1990 in 23 OECD countries has been 1.62%, almost exactly the same as the US rate of 1.66%, according to Andrew Biggs. He found the US's "excess growth" rate to rank ninth of the 23 -- lower than in nations famous for the national health care systems such as France and Britain.

The implications are that ...

(1.) The steadily rising cost of health care -- the increasing portion of national income it consumes -- that is seen everywhere is in fact natural and good, beneficial, and what people want.*

(2.) Any political attempt to stop this natural and beneficial process is only going to get people angry, and be doomed to fail.

(3.) The higher level of health care costs seen in the US compared to other nations is not due to their cost rising faster in the US -- their growth rate is not higher here -- but due to higher "base level costs". In particular, salaries throughout the US health care sector are far higher than in other countries like France, Canada, and the U.K. (Mankiw on this.)

But the implication of this is that if the goal is really to get US health care costs closer to the level seen in those other countries, the method is going to require taking on a wide range of powerful health industry groups extending from the American Medical Association to the United Healthcare Workers Union to slash the real incomes of their members over time -- which seems politically problematical at best, and is something nobody in all the health care reform debate has had the nerve to even mention yet.

This is not to say that there aren't a whole lot of major inefficiencies in the US health system to fix to obtain "one off" cost savings -- I could give a list, and maybe I will, but that will be for another post. However, "one off" savings, as valuable as they may be, don't "bend the cost curve".

The bottom line here is: You can pretty much dismiss the mantra that was coming from the left for a while there, "Health Reform is Budget Reform". There's no credible health care reform proposal in sight to "bend the cost curve down" -- and to the extent that health care is a "superior good", you shouldn't want there to be.

If you want legislated health care reform, want it for other reasons.---

* This, of course, does not mean that everyone's effort to have everyone else pay for it, so they can escape their own costs, is good and beneficial, "natural" though it may be. Quite the contrary. But that's another story.